How Big a Bang for Trump’s Buck? (Wonkish)

Back in the days of austerity amidst depression, some of us spent a lot of time thinking and writing about fiscal multipliers. Reading Neil Irwin on the effects of the GOP’s new what-me-worry approach to deficits, I found myself thinking back to that discussion, and what it implies for the short-run economic impact. Specifically: what kind of multiplier effect should we expect to see here?

The most convincing evidence on multipliers, in my view, has always come from natural experiments: cases in which we know from the historical political record that governments were imposing large changes in taxes and/or spending, and we can see the effects of these fiscal shocks on growth relative to what was previously expected. (Attempts to use fancy statistical techniques to extract fiscal shocks have worked much less well.)

A lot of this work came from the IMF. In 2010 the Fund produced a report on austerity policies (Chapter 3) that was in effect a response to the “expansionary austerity” literature, using the historical record to assess past austerity policies. That analysis suggested a multiplier of about 0.5 – that is, a 1 point cut in government spending as a percentage of GDP would reduce output by half a percent.

However, past austerity took place under normal monetary conditions – that is, central banks could and did offset fiscal contraction by cutting interest rates. By contrast, austerity after 2009 took place in countries where interest rates were already zero and could not be cut further. You would expect the multiplier to be larger under these conditions, and sure enough, a variety of studies – most influentially Blanchard and Leigh – found a multiplier of around 1.5, three times as large. (Nakamura and Steinsson’s clever use of regional data on defense spending within the U.S. as a measure of the multiplier came up with a similar number.)

So now we have a stimulus from tax cuts and spending increases in an economy already down to 4 percent unemployment, where the Fed is already raising rates to head off potential inflation. That is, we’re looking at normal monetary conditions, where we’d expect a smallish multiplier.

I’m having a hard time figuring out exactly how big a stimulus we’re looking at, but it seems to be around 2 percent of GDP for fiscal 2019. With a multiplier of 0.5, that would add 1 percent to growth.

That said, I’d suggest that this is a bit high. For one thing, it’s not clear how much impact corporate tax cuts, which are the biggest item, will really have on spending. Meanwhile, unemployment is only 4 percent; given Okun’s Law, the usual relationship between growth and changes in unemployment, an extra 1 percent growth would bring unemployment down to 3.5%, which is really low by historical standards, so that the Fed would probably lean especially hard against this stimulus.

So we’re probably looking at adding less than 1 percent, maybe much less than 1 percent, to growth. This isn’t trivial, but it’s not that big a deal.